CHART DU JOUR: V-SHAPED THIS CHART IS NOT

Given the free fall of 2008-2009, these core metrics should be recovering faster

Table volume is making lower highs and slots have been consistently in the “slow growth” camp

“Return to peak EBITDA” analysis is a pipe dream. Structurally, LV and most of domestic gaming appear permanently impaired.

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06/12/12 01:53 PM EDT

The Failure of Washington

The bulls, Tim Geithner and Barack Obama have all failed us, says Hedgeye CEO Keith McCullough. Bank bailouts don’t bode well for the markets – this is clear. The failed policies of the Federal Reserve and the International Monetary Fund are getting us nowhere. McCullough doesn’t like the bailouts and neither do the markets. But don’t tell Christine Lagarde that.

“At the end of the day you can make mistakes, losers can win and I think the entire general population is sick and tired of it and that’s why there’s outflows out of equities. Markets are going lower, not higher,” says McCullough

Others thought Greece and the uncertainty with the June 17thelections were the market catalyst. That’s great. We’re going to stick to being realists and following the TRADE, TREND and TAIL durations on the S&P 500. Wishful thinking only takes you so far. This is an election year. Does the general public want to follow in the footsteps of Europe? Do they want another Hank Paulson? Not a chance.

KORS: Q4 Report Card

KORS delivered the print and outlook needed for a rebound after underperforming retail by over 20% in the past 3-months. Importantly, not only is strength coming from both retail and wholesale channels, but European sales came in among the strongest in retail with comps up +14% and sequential trends across channels accelerating quarter-to-date. Despite a more constructive outlook for FY13, KORS is still expensive. The reality is that great brands with robust earnings momentum and conservative expectations will always look expensive. We'd still rather buy FNP than KORS. If cap is a concern, then RL.

What We Liked:

Nearly every metric came in better than expected with the sole exception of tax rate disrupting an otherwise solid earnings algorithm of +58% top-line translating into +80% EBIT and +65% EPS growth (would have been +80% at expected 40% rate).

Owned retail stores continue to drive top-line growth with store productivity approaching $1,400/sq. ft. among the best in retail and comps coming in above the originally guided range as well as Q1 outlook of ~35% coming in 2x Street expectations and above our above consensus +32%E. In addition, store growth of ~70 in FY13 is modestly higher than the 68 we had modeled and the Street at 64. With the retail channel accounting for 2/3 of FY13 growth in our model (see table below), this is perhaps the most notable takeaway in the quarter.

Margins were up sharply following a warehouse transition and 1x costs associated with the IPO last quarter driven primarily by significantly better gross margins in addition to SG&A leverage. While much of the improvement in gross margins can be attributed to greater retail and int’l mix accounting for over 100bps of the +180bps expansion, wholesale improved as well providing an added boost. With a 5pt sales mix shift to retail in F13, we expect channel mix to provide at least a 100bps tailwind. As such, we think the company’s outlook for margin contraction in FY13 is conservative.

KORS’ initial FY13 outlook suggests significantly stronger sales and earnings growth than expectations withfull-year comp growth of at least 20%, revenues +30%-40%, and EPS growth of 40%+ compared to comps in the mid-teens and earnings expectations in the low 30s settling one of the biggest concerns headed into the quarter.

What We Didn’t Like:

Perhaps the biggest negative in the quarter is the sales/inventory spread, which eroded 18pts to -2% with inventories up 60% outpacing sales growth of 58%. We’re willing to give them a pass as swings here can be expected to support aggressive store growth, but this is undeniably gross margin bearish near-term.

Expenses were leveraged in the quarter; however, we expect slight deleverage in FY13 as the company adds headcount to support global growth and related infrastructure. Adjusting for IPO related 1x expenses in FY12, we’re modeling ~60bps of operating margin expansion driven by +70bps gross margin expansion offset by modest SG&A deleverage.

In addition, CapEx is headed higher. CapEx has been running at 6.5%-7.5% of sales over the last three years and is expected to increase to 9%-10% in F13 to support store growth and various infrastructure investments. While this will subdue FCF generation over the intermediate-term, the reality is that the company is investing when it should to grow what is a nascent brand overseas and drive top-line growth even if at the expense of further upside to earnings growth. UA is a great example of a company that executed a similar strategy over the past year proving that top-line preservation is more critical than margin expansion in a brands’ early growth stage.

All in, KORS is expensive and likely to remain so over at least the intermediate-term. We’re shaking out at 40% revenue growth in F13 and 26% in F14 and $1.20 and $1.57 in EPS respectively.

Casey FlavinDirector

Accountability and Outlook: Here’s a look at KORS’s variance between guidance and actual, as well asinitial outlook for F13 vs expectations:

Highlights from the Call:

Expense Expectations:

Marketing spen - are spending 'a lot of money in the social media space' - has been solid sales driver thus far

Looking to hire a COO and add'l headcount to grow global business - expect expenses to reflect these efforts by 2H F13

Will have more detail re e-commerce plans over next 6-months - re bringing in-house

Most expenses related to warehouse transition already incurred, now a matter of increasing utilization

Europe & Comp Growth:

The brand is resonated at retail at both free standing stores and at department store business

At wholesale, apparel will be larger than accessories due to stores that are focused there vs accessories

Accessories will be the lead in KORS owned stores

Will be stronger positioned this time next year as one of the leading players in UK, France, Germany, Italy and Spain, etc as a leading accessible lux player

Europe strength a reflection of getting product to the region

Expect NA to have higher comps over LT due to greater brand awareness

Expect NA and Europe to comp ~20% in F13, Japan slightly lower

Demographic - Customer:

Hasn't changed since IPO - still ~35 years-old women

After Europeans, South Americans are the strongest global consumer - KORS doesn't currently have any stores there

Category Performance:

Monogram has already reached 25% as percent of sales - sooner than expected, very conscious to not let it grow too large

Accessories at 75% achieved that threshold sooner than expected as well - likely to grow to 80%-85% of revs over time

Small leather goods continues to be the strongest performing category

Margins - Store Performance:

Very little differentiation in comp store performance b/w stores that are 1,3,5 yrs old

Full price stores are highly productive, not seeing tremendous differentiation between full-price and outlets in terms of productivity

Wholesale gross margins also improved in the quarter

Marketing by region - spending at much higher levels in Europe and Japan relative to more mature brands

View is they have to 'act bigger than they are' when marketing to a market

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ALL ABOARD: We’re going cruising

Hedgeye Gaming, Lodging and Leisure Sector Head Todd Jordan’s chart on cruisers, those who travel on cruise ships, shows some surprising trends.

The median age of the cruiser has fallen significantly since 1986 as you can see below. It’s since hovered between 46 and 52 for the last few years. Younger people are digging cruises. The 60-year-old plus crowd is of course the largest customer base but cruises could be coming back in a very cool, hip way. Using our TRADE/TREND/TAIL model, Jordan has a sunny outlook for cruise companies, specifically RCL and CCL.

DEAL WITH IT: The age of central planning

Hedgeye CEO Keith McCullough says that the International Monetary Fund (IMF) is basically losing its mind. It’s very good at taking money and throwing it at a problematic country. That’s nice, but it doesn’t fix anything in the long run. Central planners seem to be content with bailing out anyone who wants one and we don’t like it. Remember: the definition of insanity is to do something over and over again, expecting different results.

Back in America, Chicago Federal Reserve President Charles “Chuck” Evans is pushing yet another round of easing. He wants more of the same thing despite the long-term issues we have in this market. McCullough mentioned this morning that we are going to have “big societal, market and volume problems” until we stop further quantitative easing. Halloween isn’t until October and this is truly scary.

The big money (pensions, sovereign wealth funds, etc.) is trying to do one thing right now: not lose money. Well, how do you do that? You flock to safety. That means US Treasuries, German Bunds and the US Dollar. We are currently long TLT and UUP. Come June 20 when the Board of Governors of the Federal Reserve meets, we’ll truly know what’s on the table in terms of further easing. Until then…

RESTAURANT SENTIMENT: CBRL, CAKE, JACK

Short interest data released yesterday shows that for the most recent two-week period, there were three significant changes in our sentiment scorecard: CBRL, JACK, and CAKE.

Here is our most recent iteration of the Hedgeye Restaurants Sentiment Scorecard, updated for yesterday’s release. Our call-outs are below.

Sentiment Scorecard Callouts

CBRL: Cracker Barrel has been one of the best performing casual dining names over one week, one month, six month, and one year durations. The stock’s outperformance versus the S&P 500 did not materialize until late April as investors gained conviction that gasoline prices were rolling over. Investor sentiment on the stock has changed dramatically; as the sell-side has upgraded the name, the buy-side has covered shorts, bringing short interest from 10.1% 14 weeks ago to 6.9% as of the most recent period. This is a call we missed but should have called; we have done so previously on the short side when gas prices were turning higher so it hurts to miss this one.

CAKE: Investors have been turning increasingly bearish on The Cheesecake Factory over the most recent period (settlement date 5/31). Cheesecake Factory comps tend to correlate quite highly with the ISCS Chain Store Sales Index (YoY change) and that index has been declining since mid-May. This would not fully explain the drop off in sentiment, but we will certainly be revisiting it as we near the company releasing guidance. Last quarter, it helped us to find a more-accurate-than-consensus estimate for CAKE’s comps. We will be publishing a comprehensive note on CAKE ahead of earnings on 7/20.

JACK: Jack in the Box continues to win over the bears but we think that there is sufficient skepticism on the Qdoba growth story that the stock still represents an attractive long-term investment under the current outlook. From a “sum of the parts” perspective, we see plenty of upside (roughly 45%) over the next three years. We posted a note on May 8th outlining our positive thesis on Jack in the Box and, since then, the stock has gained 11% as the S&P 500 declined 3%. The quantitative setup, courtesy of Hedgeye CEO Keith McCullough’s quantitative models, is below.

Howard Penney

Managing Director

Rory Green

Analyst

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